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America’s Chinese disease (not quite what you think)

October 19, 2009 5:07 pmOctober 19, 2009 5:07 pm

Fed chairman are expected to speak in code, so that reading their remarks is a bit like watching the famous scene in Annie Hall where the conversation between the lovers is subtitled with what they’re really
saying. So when Ben Bernanke says this:

Another set of lessons that Asian economies took from the crisis of the 1990s may be more problematic. Because strong export markets helped Asia recover from that crisis, and because many countries in the region
were badly hurt by sharp reversals in capital flows, the crisis strengthened Asia’s commitment to export-led growth, backed up with large current account surpluses and mounting foreign exchange reserves.
In many respects, that model has served Asia well, contributing to the rapid growth rates in the region over the past decade. In fact, it bears repeating that evidence from the world over shows trade openness
to be an important source of economic growth. However, too great a reliance on external demand can also pose problems. In particular, trade surpluses achieved through policies that artificially enhance incentives
for domestic saving and the production of export goods distort the mix of domestic industries and the allocation of resources, resulting in an economy that is less able to meet the needs of its own citizens
in the longer term.

But does the United States dare put pressure on the Chinese to do that? People constantly say that we can’t risk it — that we’re dependent on China to keep buying our debt. Yet this is all wrong
under current circumstances.

How do I know it’s all wrong? Here’s one way to think about the issue that I haven’t seen anyone else put forth (if they have, I’ll be happy to give credit.)

Right now, we’re in a situation in which conventional monetary policy is hard up against the zero lower bound; rules of thumb that track past Fed behavior suggest that the short-term interest rate should be -5%
or lower. To partially make up for its lack of traction, the Fed is engaged in massive “quantitative easing” — a misleading term, but I guess we’re stuck with it. What it basically means
is that the Fed is selling Treasury bills or their equivalent (interest-paying excess bank reserves are essentially the same thing), while buying other assets, expanding its balance sheet enormously in the process.

What kinds of other assets? Mortgage-backed securities; securities backed by credit-card debt; longer-term government debt; etc..

One type of asset the Fed has not been buying is foreign short-term securities. But that’s not because such purchases would be ineffective. On the contrary, selling domestic short-term debt and buying
its foreign-currency counterpart is the essence of a sterilized foreign-exchange-market intervention, which is a time-honored way of gaining a competitive advantage and helping your economy expand.

And some countries have, in fact, made foreign-currency purchases a part of their quantitative easing strategy — Switzerland in particular.
The only reason the Fed isn’t doing this is that we’re a big player, and can’t be seen to be pursuing a beggar-thy-neighbor strategy.

But now ask the question: what would the effect be if China decided to sell a chunk of its Treasury bill holdings and put them in other currencies? The answer is that China would, in effect, be engaging in quantitative easing on behalf of the Fed. The Chinese would be doing us a favor! (And doing the Europeans and Japanese a lot of harm.)

Conversely, by continuing to buy dollars, the Chinese are in effect undermining part of the Fed’s efforts — they’re conducting quantitative diseasing, I guess you could say, hence the title of this
post.

The point is that right now the United States has nothing to fear from Chinese threats to diversify out of the dollar. On the contrary, if the Chinese do decide to start selling dollars, Tim Geithner and Ben Bernanke
should send them a nice thank-you note.

– not because I didnt laff heartily on your ” quantitative diseasing ” (now THATS a funny bit of freakonomical contrarianism if there ever was one!) Luv the idea of us all benefiting from our
profligate,promiscous, supersized consumerism.

What scares me is “What kinds of other assets? Mortgage-backed securities; securities backed by credit-card debt; longer-term government debt; etc..”

The real SOURCE problem here is the institutions, pension funds, college endowments, governments etc who bought and continue to buy worthless derivatives and paper junk which enables this enormous leveraging.

Thank you Dr. Krugman for this post. I think that both level of consumption and industrial employment will have to be rebalanced between China and US in coming years. We need to see revaluation of Yuan and
its implications from all possible angles.

Predictably, Kudlow is braying to-nite about the demise of the dollar (says that’s why he’s wearing a black tie – which is just as blue as the set background), then bemoans Bernanke not mentioning
the dollar even once in his speech today, then accuses the Obama administration of treating the U.S. like ‘just another C+ country’ in the world, then says Bernanke is just creating another speculative
bubble.

Next up is the author of the Barron’s piece.

Hmmmm – if Kudlow’s getting red in the face, things must be looking up for us economically !

Dr Krugman, this is head spinning stuff.. can you write more on this topic please? Why does a stronger dollar not hurt the USA as much as a stronger currency hurts other countries? This is a very complicated balance
it looks like. If China diversifies out of the dollar, we would pay more for gasoline and other imported goods right? Since America imports so much from China, how can a weak dollar be considered good unless
we know precisely at what point the US economy will start producing things that we buy from China today?

Interesting, but on sterilized intervention… My take is that (portfolio effects duly acknowledged), sterilized intervention is generally believed to be ineffectual to actually change the path of the currency.

If I recall correctly (it has been some time and I do not have that great paper at hand), your model of currency crisis assumed a Central Bank doing sterilized intervention (under fixed rates, I know, but the ineffectiveness
generalizes to floating rates as well) and eventually leading to the collapse of the currency.

That said, I agree with your view on China. Should they dump USTs, Tim and Ben should throw a party.

So will the Chinese “ever” be paid back by the US? They know they will not, but they don’t really care. What matters is that exports to the US helped them build a robust production base
and that they are going to keep. Or are they? The majority of companies I think have R/D departments outside China and off-course sell outside China. China is just a middle-man in the process, and
that could change, maybe bringing Africa to the modern map.

US gave Chinese factories and in return they give the US products for free. It may not be a fully balanced deal but it is not that bad. I mean, if they start consuming they may get to keep some of the products for
themselves.

I like. This is good piece founded on solid economics. I have not come across this argument before, and I’m yet again amazed by your ability to breakdown issues in simple terms. The only question in my mind
now is: how will this play out in the real world where market reactions are not as straight forward as mental constructs.

While it is true that the Chinese selling T-bills is having the same easing effect as the Fed selling the dollar, the main difference is that in the former, the Fed gets nothing while in the latter, the Fed gets
money to finance our spending. The fear of the Chinese diversification is less about the actual easing but is more about the implication of a less appetite for dollars and T-bills. Ben Bernanke would be terrified
if the Chinese stop buying T-notes all together. What Ben wants is that the Chinese reevaluate their Yuan (and thus make the dollar cheaper) and yet they keep buying our T-bill (and hence, Tim Geithner implicitly
assure the Chinese a stronger dollar).

The other thing that I don’t understand is this. The US in the past year has a saving rate in excess of 5 percent. That means the saving amounted last year to about more than 700 billion, and more likely
more than a trillion. Doesn’t that mean that we pretty much financed more than 2/3 of last year’s federal deficit?

Apologies for sounding dumb but not being trained in economics, I am missing some links in your argument Dr. Krugman. I look at the situation as a three-country model (say) A – for America, C – for
China and E – for Europe. Right now, the Fed is trying to put a lot of $ bills in the hands of Americans. The Chinese, by buying T-bills are sucking the $ bills away and putting it back in the Fed’s
vaults (if I read the argument right). If C tried to diversify its foreign currency holdings, it would be putting lots of $ bills in the hands of E pushing the Euro’s value up which would hurt their exports.
So far I follow. But how does this help A? The fact is that C is a net exporter and therefore it is debatable whether a weaker $ will cause C to start buying more goods from A or anyone else for that matter.
The folks in C are habitual savers and it is hard to see a stronger local currency change that very much. At the same time, I don’t see why E should buy more from A. They can buy low-end goods from C
and they make the high-end themselves. So where is the need for goods from A? The mix of exportables and their relative demand also have a role to play I think. If neither E nor C want goods made in A (for whatever
reason), then whether the $ bills are lying in the Fed’s vaults or the ECB’s vaults ought not to make any difference. However, if there is some country that wants a lot of American goods then may
be this flow of $ will somehow manifest itself in higher exports for A. But will it be enough to wipe out the big deficits already accumulated?

A’s best hope is to stimulate domestic demand such that it substitutes imports. Perhaps investing in TGV-type train systems between D.C., NY, Philly, Boston, etc. is one such avenue. It will create jobs –
which is what the govt. wants. It may result in de-congesting the big cities (hopefully) pushing rents down which in turn would be good for inflation – this is something the Fed wants. It may also result
in lower consumption of oil – which could reduce the import bill a great deal, and last but not least – it may improve productivity by reducing the time spent commuting. All in all, Keynes was
right – well thought out public works programs do work.

China would not be doing the US a favor at all by selling a portion of its treasury holdings, because this would make future bond auctions by the Treasury department more difficult. We have an enormous deficit to
finance- if China puts its UST holdings on the market, the supply of Treasury bonds goes up, their price goes down, and the yield the Treasury will have to offer will be much higher. This is crazy. The US has
everything to fear from China diversifying out of the dollar.